Wednesday, November 12, 2008

Hedgies in the Hot Seat

So the heaviest of Wall Street Heavies—George Soros, Philip Falcone, John Paulson, James Simons and Ken Griffin—are making their way to Capitol Hill even as we write this.The five, supposedly chosen because they all made more than a billion last year, will testify before thoughtful and deliberative Congresspersons who really want to learn about this hedge fund business of ours, in order to make sure that Washington regulates the hedge fund industry as intelligently and rationally as possible.

We’re joking, of course.

What those Congresspersons want to do is say as many words as possible before their time limit expires and the Chairman gavels them to get to the point, before they run off to their next meeting.

We know: we’ve testified before one such committee.

On the one hand, it was kind of cool. They were as diverse a group of individuals as you’ll ever get under one roof; about as American as could be. On the other hand, they were, for the most part, blowhards. All it all, it was quite depressing.

The typical “question” went something like this:

Congressperson Sludge: “Thank you, Mr. Chairman, for this opportunity to get at the heart of the concerns of my constituents in the great state of [fill in your average state]. Now, Mr. Hedge Fund Manager, I want to ask about these hedge funds and why these hedge funds are hedging, and what they hedge. Is it not dangerous when so much money is in the hands of so few people with no accountability to the American people, this rabble you’re talking about, who do most of working and paying and living and dying in this town—”Chairman Bile (banging gavel): Congressperson Sludge, you’re doing Jimmy Stewart from “It’s A Wonderful Life” again. Next time I hold you in contempt!"

Congressperson Sludge: “I apologize, Chairman Bile. What I want to ask the hedge fund persons is but before I get to that let me say that my state is the banjo capitol of the world, and banjos are the backbone of our society, and your corrupt influence on our financial structure should not be tolerated, except, of course, in the event of war—which I voted against, although it seems to me—”

Chairman Bile (banging gavel): Congressperson Sludge, your time is up. [Looking around.] Sludge? Where did he go?Today’s hedge fund line-up is quite impressive, particularly because Congress finally picked one of the right guys to talk to: John Paulson, who got this whole subprime mess dead right.

Too bad nobody invited him to the table when his namesake, Henry Paulson, and the academic theorist Ben Bernanke, whose main qualification for the job of Fed Chairman seems to be that he studied the Great Depression and wrote a paper about it, were trying to figure out how to deal with the subprime crisis.

If they had, the Feds might not have gone off on tangents like the supposed “naked short-selling” crisis that some Congresspersons actually became convinced was what drove Fannie Mae to ruin.

Of course, just this week, Fannie Mae reported a $29 billion loss. And nowhere in the press release did we see a reference to the “naked shortsellers” who might have caused the loss.

The content contained in this blog represents the opinions of Mr. Matthews.Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

For the industry, a good opportunity to say its piece. A great example of proactive defense from the industry In the UK, for example, is this open letter ("Hedge Fund Community Albourne Village Rejects Blame"):http://hedgefundblog.jobsearchdigest.com/178/hedge-fund-community-rejects-blame/

ere is the deal. The world has been shifting from a supply side monetarist economy ever since Reagan stepped down. Bush 1 and 2 and Clinton were all Keynesian economics believers pretending to be supply-siders. As the Keynesian stimulus based economics looks a little like supply side economics, people may not have noticed the liberal shift. Now twenty years after Reagan, several things have happened to create this perfect economic storm:

1. Liberal Keynesian economics has taken over most government and corporate CFO thinking, eliminating the old idea of a paper based economy stabilized by actual money in the bank to back up lending (fully monetized lending).2. This has caused a shift from a monetized economic policy of 'what you see is what you get' to a policy that had been replaced by printed money, extended debt and failed Keynesian economics. People have been looking only at the supply side economics aspects and not the solid aspects of institutional fully monetized funding policies.3. The result has been the current debt and liquidity crisis that has no solution because failed economic institutions are not being allowed to fail, as hard as that sounds.4. With the combined 8 years of Bush spending out of control, trillions in additional debt due to the failure of the flexible economic policies of the Keynesian economists, the inability of the population to repay that debt is self destabilizing. The millions of boomers who are now near retirement with no retirement nest or no savings and the end of the Reagan economy of a stable fully monetized supply side economics now have not a recession but a genuine depression in which the exact opposite that is needed will be happening over the next four to eight years.

Even Karl Marx said "I am not a Marxist".

All of the false financial opportunists masquerading as financial gurus have made an egregious assumption that the money being stolen and spent by the bureaucrats to solve this financial crisis can actually be paid back by the generations being taxed to pay it.

In ten years, a look back at the poverty and misery and the collapse of nations that continues, one might consider that in the beginning government failed to maintain laissez-faire while private enterprise failed by its embrace of phony printed money provided by governmental Keynesian fools.

All of this activity involves the real collapse of world economies in the shift from Monetarist to Keynesian economic management and that shift has created a nation that is nothing less than a trailer park whore who is running through the street trying to grab that dollar being pulled on a string through the park by her pimp. Trying to save us with government is like the last humans consuming the suicide pill On The Beach(es) of Australia after the nuclear holocaust has already killed everybody else.

mr mathews,the internet is wonderful. I found out that you were a financial supporter of Rep Christopher Shays of CT. Guess what House Committee he was on? Now I know why you did not print my comment on your latest piece on hedge fund managers appearing tomorrow before that very committee. Jeff Mathews IS making this up !!!!!!! I think you are a hypocrit.

One of the consequences will be more donations from the hedgies to our peoples' representatives. We saw it when right wing groups started going after Microsoft a few years ago, MS felt the pressure to start giving away some gift bags.

Greg is correct: the hearing is Thursday. "So I was a little early," to quote from another movie--'Some Like It Hot'.

Robert needs to use a spell-checker. As for whatever comment he made regarding hedge funds that we did not print here, I urge him to write it again, using proper English, with correct punctuation. Otherwise, we congratulate him on his use of "Google" search. You really can find anything on the internet.

"Anonymous" asks a great question that must be on the minds of many investors these days--investors in underperforming hedge funds, underperforming private equity funds, underperforming mutual funds and even "safe" money market funds that are suddenly no longer safe.

What, after all, is the point of any of those asset-management businesses if they fail to protect their investors?

The answer, as Warren Buffett says, is quite simple: when the tide goes out, you find out who's swimming naked.

Speaking of Warren Buffett, we note that he ran a hedge fund for 13 years. He made his investors--and himself--very rich. And nobody complained.

Jeff, your answer to anonymous question on hedgies usefullness is depressing. It was a bit like in your previous post about Congressmen totally not getting it. I think a question is about how is this useful for the society - not a few rich investors whose money you are managing. Too bad you wouldn't even think about it this way, even when asked directly.

The answer to the question of 'why hedge funds?' is simple: done well, they work well for their investors.

Warren Buffett ran a hedge fund for 13 years, and made dozens of not-rich people very wealthy in the process.

Furthermore, Buffett himself invested a mere $100 in his hedge fund and made himself $25 million thanks to performance fees. He rolled that money into Berkshire Hathaway shares now worth $50 billion, mostly pledged to helping Bill Gates deal with world health problems.

That's not a bad thing for society.

But it's not my place to defend a bunch of yahoos or explain why rich people gave their money to idiots who couldn't manage it, and I'm not going to.

I think the answer to the anonymous question--and this is coming from some guy who thinks most hedge funds, or perhaps most hedge fund investors (supposedly to be sophisticated,) don't know what they are doing--is something like the following:

What a hedge fund, or a mutual fund, or a portfolio manager in general, does is to allocate resources. Similar to how a bank is supposed to channel savings into investments (or to those that seek to make investments,) funds are supposed to help the market by increasing efficiency.

A good example of this in practice would be arbitrage hedge funds. You can probably buy/sell a foreign stock or exchange currency at close to the actual (market) value due to the activities of arbitrage funds (others do a similar thing such as market makers and trading desks but I'm thinking of cases where that isn't the case.)

Another example would be short-selling hedge funds, who provide liquidity to the market.

Having said all that, I think the problem is that hedge funds as an investment class were in a bubble. My opinion is that there were too many funds--and don't forget that typical retail investors don't have access so you are ruling out a huge part of the market--and that probably led to poor allocation decisions, including possibly herd-like bets on commodities, speculative emerging market stocks, and so forth. To make matters worse, a lot of hedge funds use leverage so it masks their performance. There are countless funds that seem to have posted better numbers than Warren Buffett, whom I consider the best of all time, did in his prime. It shouldn't be surprising that the providers of leverage to these hedge funds--investment banks--are almost all bankrupt or receiving bailouts from the government.

I think one cannot resort to one Buffet example to prove that hedge fund industry is useful in its current form. In my humble opinion, there are at least two serious problems. First, the long term capital gain tax rate on the salary of the managers is simply obscene. More essentially, the fee structure common in the industry is not good. There is a huge moral hazard. Getting a cut of profits every year encourages use of strategies which lead to decent gains with high probability and a complete disaster with lower probability. There are plenty of those strategies, not too subtle.The expected value of the return may well be negative or subpar, but managers can earn huge salaries for a few years and then depart upon disaster keeping the bounty.

There should be a least some time horizon for taking out these profits, like vesting of options for executives. For example, profit-based fees accumulate in a special fund, and the manager starts gaining access to profit cut earned in year x only after ten years - in year x+10 - provided that he does not blow up or even produce subpar performance during this time. Such a structure would be totally OK for Buffet, but will not overcompensate majority of mediocre managers. Why the investors do not ask for such a deal, especially with new funds without much of a record, is beyond me.